Where Do We Go From Here

Globalization and Financial Crises

The growing threat of global crisis is fuelling a debate over the means available to contain and resolve it, as well as over the ways in which countries can protect themselves from its consequences (see Guitian, 1999). The world economy has become so closely integrated that not only do countries need to ensure that they manage their own economies well; they must also be ready to anticipate, and adapt to, economic mismanagement elsewhere. The first issue that needs to be addressed is determining what individual countries can do to cope with volatile capital flows. For the orderly liberalization of capital flows, a second issue needs to be addressed: the development of norms and procedures that all countries agree upon and that are flexible enough to cover all potential country situations. A few time-tested principles of international relationships are eminently well suited for the purpose at hand: a provision to allow countries a measure of flexibility; a set of common prudential norms; a principle of temporary international acceptance of restrictive measures; and a provision to allow countries to resort temporarily to controls.

The most pertinent issue, therefore, relates to ways of dealing with financial crises. Clearly, financial crises in Latin America and Asia since 1994 have drawn attention to the potential dangers of globalization of the international financial system (Arner, 1998). In order to prevent the collapse of the financial system of the countries involved and reduce the risk of potential contagion throughout the international financial system, international financial rescues of unprecedented proportions have been organized for Mexico, Thailand, Indonesia and South Korea. The magnitude of these international financial packages and the as yet indeterminate impact that they will have on the international financial system underline a number of ongoing changes in the international financial system. The basic causes of the crises and the nature of the international rescues, beginning with the Mexican peso crisis, are diverse and no uniform rules apply.

Overall, there is need for strengthening the architecture of the international financial system in the wake of these crises. The idea is to explore what can be learned from these events about the opportunities and risks of a global financial market and how the architecture of the international financial system can be strengthened to realize the potential of a twenty-first-century global economy. The time has come for a more systematic approach to strengthening national financial systems that would involve a more intensive assessment of their vulnerabilities and steps to promote reforms.

Revamping the Tools of Country-risk and Credit-risk Analysis and Management

The traditional country-risk analysis techniques were developed in the 1970s at the height of international bank-lending activities. The motivation was to develop statistical tools which would facilitate the assessment of country risk that could be associated with a given prospective borrower. It was also intended that the models would be applied to forecast the probability of risk associated with future loan transactions. Moreover, the statistical techniques were intended to supplant purely descriptive methods which were being applied by some analysts. Descriptive or informal methods of country-risk assessment relied on political descriptive information to formulate some qualitative judgements on the risk associated with loan obligations with a given country. Some countries were rated as good risks while others were rated as poor risks, without any quantitative indicator of how risk prone these countries were. In general, the main methods of country-risk analysis that have been used in the literature can be classified into four groups; namely, full qualitative methods, structural qualitative methods, checklist methods and quantitative techniques. The main statistical techniques include linear-probability models, logit models, probit models, discriminant analysis, principal components analysis and dynamic programming models. See Murinde (1996, Ch. 9) for details on these methods and their applications.

Consequently, a number of specialist agencies for analysing credit risk, political risk and country risk have emerged over the last two decades. The main ones include Moody's; Standard and Poor's; S.J. Rundt Associates of New York; Multi National Strategies of New York; Political Risk Services of New York; the Institute of International Finance of Washington, DC; International Country Risk Guide of New York; and the Economist Intelligence Unit, London.

Notwithstanding the useful models for country-risk analysis reviewed in this chapter, it is a formidable challenge to accurately assess and predict country risk. The experience of the global debt burden bears testimony to the fact that financial institutions can get country-risk predictions wrong. The main shortcoming of the main models used to predict country risk is that, in general, these models depend on expectations; analysts try to cope with expectations by tempering the models with judgement and knowledge of the underlying structure.

Moreover, the onset of globalization and the end of the cold war have introduced new complications. For example, developing economies will have to compete with one another for external finance. On the side of devel-oping-country governments, there is an increasing awareness of the need to restructure their economies and make them attractive to foreign investors. On the side of investors, there is increasing activity in monitoring the investment climate around the world.

It is therefore necessary to reconsider the traditional tools of country-risk analysis. The series of devaluations and soaring numbers of troubled banks and borrowers in Asia and other countries took many analysts by surprise. In general, the global economy and, especially, the growth and globalization of capital markets have put new strains on the system and created new challenges for risk managers. As recently as January 1996, participants in surveys of country-risk practices still focused on traditional macroeconomic measures in risk-grading country exposure (Hayes, 1998). The future lies in devising more comprehensive tools of risk analysis and management.

International Coordination of Bank Regulation

There is urgent need for bank regulators to coordinate regulation following incidents with transnational implications, such as the failure of the UK's Barings Bank and the fraudulent activity at the New York branch of

Japan's Daiwa Bank (Prasad, 1998). At the same time, local bank managers need to put in place programmes for complying with the changing international regulatory environment and international bank management in a rapidly expanding regulatory environment.

Financial Discipline

After an empirical assessment of the impact of the globalization of financial markets on developing and transition economies, Knight (1998) argues that imperfectly competitive banking sectors can react perversely to adverse economic shocks. It is found that while non-bank financial markets and institutions can enhance the competitiveness of the banking sector, there are gaps in the institutional and market structures of developing and transition economies. Eliminating these gaps may reinforce financial market discipline in developing and transition economies. Thus, international initiatives for enhancing financial system soundness should emphasize the complementary roles of market discipline and official oversight in an environment of globalized markets.

The Agenda for Policy Makers

The question of how to redesign the global financial system is a major issue confronting finance ministers, central bankers, commercial and investment bankers, technocrats at multilateral organizations, and academics.

The issues discussed by the G7 finance ministers at a meeting on 8 May 1998 included ways of strengthening the global financial system, improving cooperation between supervisors of internationally active financial firms, and fighting crime. In regard to strengthening the global financial system, five key areas were identified as requiring action: (i) enhanced transparency and data transmission, (ii) assisting countries in their preparation of integration into the global economy and for free capital flows, (iii) strengthening national financial systems, (iv) ensuring that the private sector takes responsibility for its lending decisions, and (v) enhancing further the role of the international financial institutions and cooperation among them and with the international forums (see Casson, 1998).

The Age of Internet Banking and Finance

As a result of very rapid increases in telecommunications and computer-based technologies and products, a dramatic expansion in financial flows, both cross-border and within countries, has emerged. These technology-based developments have so expanded the breadth and depth of markets that governments, even reluctant ones, increasingly have felt they have had little alternative but to deregulate and free up internal credit and financial markets. Still, for central bankers with responsibilities for financial market stability, the new technologies and new instruments have presented new challenges. It should be recognized that, if it is technology that has imparted the current stress to markets, technology can be employed to contain it. Enhancements to financial institutions' internal risk-management systems arguably constitute the most effective countermeasure to the increased potential instability of the global financial system. Improving the efficiency of the world's payment systems is clearly another.

Concluding Remarks

In a nutshell, the goal of a single global financial space is to harness the benefits of greater access to external financial markets by developing countries while reducing the risks of sudden reversals of capital inflows. The current initiatives involve strengthening the 'global financial architecture' through institutional, regulatory and supervisory reform (Financial Stability Forum, BIS), and improving country and credit risk analysis (Institute for International Finance, IIF). On the part of developing countries, more fiscal restraint is urged, along with, more controversially, more flexible exchange rates (as, for example, in Argentina, Bulgaria, Estonia and Hong Kong). Proposals to restrict capital outflows (Malaysia) and discourage capital inflows (Chile) have made little progress since neither is effective in the long run and they seem to discourage long-term direct investment. Thus, globalization of finance continues to gather pace, reaching through the internet beyond governments, parastatals, and major corporations into retail (household and SME) banking and finance. An interesting question for future research is: will internet banking and finance remove any remaining scope for regional variation? If so, will there be pockets of financial exclusion as a result of 'cherry picking' and what can be done about it?

Financial End Game

Financial End Game

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